IT AIN'T NECESSARILY SO

Many taxpayers believe that if you do not receive a Form 1099 (MISC, DIV, or INT) from the payer you do not have to report the income on your income tax return. 

This is one of the reasons for the $350 Billion “tax gap”.  The most recent study had determined that a large percentage of this gap is a result of underreporting of income by small business owners.  And this is why Schedule C businesses with minimal income or consistent losses have become an audit “red flag”.

Read my lips!  You must report taxable income if your received taxable income – regardless of whether or not you get a Form 1099.

Businesses that pay at least $600 to an independent contractor for services during the year are required to send that contractor a Form 1099-MISC.  But the independent contractor must report all income received for providing services during the year, from dollar one, whether or not they have received a Form 1099.

Some banks tell customers, when asked, that one does not have to report interest income on an account if the total for the year is less than $10.00.  This is an outright lie!  Banks are not required to issue a Form 1099 INT if the interest earned is less than $10.00, although I have seen 1099s issued for 6 cents.  But, again, bank interest is taxable from dollar one.

Just because you have not received a Form 1099 in the mail does not mean that one was not issued, and a copy sent to the IRS.  It could have been lost in the mail, or sent to a wrong address.  Do not rely on Form 1099s when determining what income to report - use your own records.

Conversely, just because you receive a Form 1099 does not mean that the income is taxable.  States will issue Form 1099-G for state tax refunds.  But the refund is only taxable if you received a “tax benefit” for it in the prior year.  Individuals who did not itemize, or who claimed a deduction for state sales tax instead of income tax, do not have to claim the refund as income. 

Many states have stopped mailing out Form 1099-Gs, and require the taxpayer to go online to download the form.  So many taxpayers, not receiving the form in the mail, do not report taxable state income tax refunds – and will very likely get a bill from the IRS down the road. 

And while we are on the subject of 1099s - do not automatically accept that the amount reported on a Form 1099 is correct.  Check it against your own records.  A few years back a client received a Form 1099 from his bank listing interest from several accounts.  One of the accounts reported on the Form 1099 belonged to another depositor, and not my client. It was included on the Form 1099 by mistake.  In such a situation contact the bank immediately and request a corrected form.

Businesses that receive payments via bank credit or debit cards, or third-party payers like Pay Pal, began to receive a 1099 series form this year (for payments made in 2011), and in the future will have to separately report the income from these 1099s on their Schedule C or entity tax return.  But the entire amount reported on the 1099 as paid by the bank or third-party is not necessarily taxable income.  Again you must rely on your own records to determine the correct amount of gross receipts to report on the total income line.

All the more reason to keep good, contemporaneous records of both income and expenses – and why you may need the help of a competent tax professional.

TTFN

FALL INTO THE GAP!

The Internal Revenue Service has released a new set of tax gap estimates for tax year 2006.  The $300 Billion number for net uncollected tax that we had been using now looks like closer to $400 Billion.  

“The new tax gap estimate represents the first full update of the report in five years, and it shows the nation’s compliance rate is essentially unchanged from the last review covering tax year 2001.

The voluntary compliance rate — the percentage of total tax revenues paid on a timely basis — for tax year 2006 is estimated to be 83.1 percent. The voluntary compliance rate for 2006 is statistically unchanged from the most recent prior estimate of 83.7 percent calculated for tax year 2001.”

The IRS suggests taxpayers did not pay $450 Billion on time in 2006. The tax agency eventually collects around $65 Billion was collected via audits and late payments.  The result is a net tax gap for 2006 of $385 Billion, $95 Billion higher than the $290 Billion previously estimated for 2001.

The increased gap is largely due to “the growth in total tax liabilities. In addition, some growth in the tax gap estimate is attributed to better data and improved estimation methods.”

According to the Service -

"As was the case in 2001, the underreporting of income remained the biggest contributing factor to the tax gap in 2006."   

The complete breakout:

 •Under-reporting accounted for an estimated $376 Billion of the gross tax gap in 2006, up from $285 Billion in 2001.

•Tax non-filing accounted for $28 Billion in 2006, up from $27 Billion in 2001.

•Underpayment of tax increased to $46 Billion, up from $33 Billion in the previous study.

The IRS found -

“Overall, compliance is highest where there is third-party information reporting and/or withholding. For example, most wages and salaries are reported by employers to the IRS on Forms W-2 and are subject to withholding. As a result, a net of only 1 percent of wage and salary income was misreported. But amounts subject to little or no information reporting had a 56 percent net misreporting rate in 2006.”

So increased 1099 reporting is to be expected, which has already begun with the new Form 1099-K.

The biggest single component, representing 27% of the $450 Billion estimate, is “business income” for individuals (on the Form 1040), which accounted for $122 Billion of the under-reporting amount – and area where there is minimal third-party reporting.  “Small corporations” (assets less than $10 Million) under-reporting was only $19 Billion.  I expect most of this is from under-reporting on Schedule C.

There is no doubt from these findings that Schedule Cs will be an audit target, especially those with consistent losses. 

However – I still believe it is bad advice to tell ALL taxpayers who have a Schedule C business to incorporate.

As I have said in the past –

“The decision to incorporate a business requires careful review of all the specific facts and circumstances of the individual situation. And taxes are not the only consideration. In a majority of cases it is not financially beneficial, either in the short or long term, to incorporate.

While incorporating will certainly reduce one's 1040 audit risk, it is very often not the best idea for the average sole proprietorship. Incorporation can generate much more paperwork, recordkeeping, federal and state tax filings, costs, and general all-round "agita" than it is worth.

The advice that one should incorporate solely for the purpose of avoiding an audit seems to me to be saying, ‘If you want to cheat on your taxes you can incorporate and the IRS will not audit you’. It is not good tax or financial advice.

An IRS audit is not something that should be avoided at all costs. Tax returns should be prepared, and decisions about choosing a business entity should be made, in such a manner as to generate the absolute least amount of federal, state and local taxes (income and payroll) within the parameters of federal and state laws. If you will pay less tax (income and payroll), fees and other costs by filing a Schedule C you should do so, honestly and ethically, and not worry about being audited. 

If you are reporting all of your income, deducting only legitimate and documented expenses, and keeping good records then any audit should result in “no change”.

Besides, as I previously reported – less than ½ of 1% of 1040s are actually chosen for a “sit down” audit.

PS - Click here to see a larger version of the above map.

TTFN

DON'T FALL IN TO THE GAP!

As I mentioned in this past Saturday's BUZZ post, the Treasury Department has issued a report titled "Update on Reducing the Federal Tax Gap and Improving Voluntary Compliance", which deals with identifying and attempting to close the "Tax Gap".

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No, the Gap clothing store has not been taken over by the IRS for back taxes, nor has the IRS attempted to raise income by selling jeans with "1040" and "IRS" patches on the back pocket.

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According to the report the Tax Gap is - "the aggregate amount of true tax liability imposed by law for a given tax year that is not paid voluntarily or timely". In other words - the difference between what should be collected and what is collected.

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In the Appendix titled "Understanding the Tax Gap" it states - "The Internal Revenue Code places three primary obligations on taxpayers: (1) to file time returns; (2) to make accurate reports on those returns; and (3) to pay the required tax voluntarily and timely. Taxpayers are compliant when they meet these obligations. Noncompliance - and the tax gap - results when taxpayers do not meet these obligations."

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As I mentioned in the BUZZ entry, "the IRS estimated this gross tax gab to be approximately $345 Billion". For as long as I have been hearing about the Gap it has been at least $300 Billion.

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The report tells us that there are three (3) sources of the Tax Gap -

• Underreporting (not reporting one's full tax liability on a timely-filed return);
• Underpayment (not timely paying the full amount of tax reported on a timely-filed return); and
• Nonfiling (not filing required returns on time and not paying the full amount of tax that should have been shown on the required return).

A major contributor to the Tax Gap is the "underground economy", described as "the value of goods and services that elude official measurement". We mean the many true "cash" businesses, both legal and illegal in nature, income from which is either grossly under reported or not reported at all. The report indicates that "tax due on illegal-source income" is "not included in the tax gap". Imagine the size of the true Tax Gap if illegal income was included!

Income from "entrepreneurial" activity is taxable whether the activity is legal or illegal. The income of a drug dealer or prostitute is subject to tax just as the income of a barber or the owner of a corner deli is taxed. Remember, it was the IRS and not the cops that finally got Al Capone!

Considering the massive federal deficit, Congress is going to look very closely at ways to reduce the Tax Gap, as well it should (although it should also look into spending less money).

The report discusses methods to "Reduce Opportunities for Evasion" by implementing and expanding information reporting authorities.

"To improve and minimize error, Treasury and the IRS have been focused on implementing several new information reporting regimes recently authorized by Congress."

Two "new information regimes" are identified -

"Credit and debit card payments to business. Starting in January 2011, organizations that process credit and debit card payments for merchants must annually report the amount of these payments to the recipients and the IRS". I personally have no problem with this new "regime".

"Cost basis reporting. Starting in 2011, brokerage firms must annually report cost basis and holding period information to customers and to the IRS in addition to gross proceeds from securities transactions". I do believe that, as a tax preparer, no one single item of tax law enacted in the new millennium has pleased me more than this new "regime". Unfortunately the starting date is still years off, and it will really be several more years after 2011 before complete cost basis reporting will occur. Taxpayers must still maintain good timely records of all investment purchases.

The report also discusses several controversial proposals included in the Administration's FY 2010 budget -

1. Require businesses to issue Form 1099s for payments for services of $600 or more to corporations. Currently Form 1099-MISC for "nonemployee compensation" and the like do not have to be issued to corporations.

2. Require landlords to issue Form 1099s for payments made to "any service provider or contractor that performs work on rental properties."

3. Require contractors to provide their Taxpayer Identification Number (TIN) to the businesses form which they receive payments, similar to employees providing Social Security numbers to employers, and also require businesses to "verify" the validity of the TIN. If a contractor does not provide a valid TIN the business would be required to withhold tax from payments made to the contractor. This is very similar to a NJ law that applies to a NJ business who pays a contractor to repair or improve business property.

4. Increase by 100% the current per-return penalties for failure to file most information returns.

5. Require that all corporations and partnerships that must file a "Schedule M-3" file their 1120 or 1065 electronically.

6. Require tax preparers who file more than 100 tax returns (I assume 1040 series) in a calendar year to file these returns electronically.

Here is my 2+ cents on the above proposals -

1. I have no real problem with expanding the 1099 requirement to include corporations.

2. A great many "landlords" are individual taxpayers (1040 filers) with a 2-family or 3-family home who live in one unit and rent out the other(s), or who seasonally or annually rent out vacation property. I oppose adding additional unfamiliar recordkeeping and form file requirements for such "individual" taxpayers, especially if penalties are to be doubled.

I have no problem with rental activities that are truly a business, such as corporations and partnerships that own and rent apartment buildings or commercial properties, being subject to this requirement - but not John and Mary who rent out the 2nd floor of their home.

3. I would not oppose the requirement for a business to verify the accuracy of a contractor's TIN or EIN upfront only if the IRS provided a simple and easily accessible online procedure for doing so, and the "business" that is required to do so is limited to a true "trade or business" activity and not broadened to include individual landlords discussed under Item #2.

However, while I know full well why the IRS wants it done (and cannot really argue with their thinking), I do not at all like the idea of forcing businesses to withhold federal income tax on non-wage payments.

If businesses are already required to issue a Form 1099 to all entities to whom they pay $600 or more for services why is this additional procedure necessary?

4. While I do agree that penalties are necessary to "encourage" timely and accurate filing, I also believe that in many cases the excessive nature of some penalties also encourages non-filing and non-payment. IRS penalties and interest can accrue to such a state that the accumulation is substantially greater than the actual tax due. As a result many taxpayers, individuals and businesses alike, simply "walk away" from tax obligations - obligations that may have been paid either partially or in full if the P+I accumulation was not so intimidating. This is why I support a federal tax amnesty program, and why I am hesitant to increase existing penalties.

5. I would not oppose this requirement if the IRS provided the affected taxpayers with a free way of submitting the returns directly to the IRS online at the Service's website. See my comments on #6 for more details.

6. I am not against electronically filing tax returns. I file NJ tax returns electronically via the free online NJWebFile service whenever appropriate. Actually I am required to file full-year resident state income tax returns electronically by NJ law, unless the client tells me not to do so by giving me a signed "Opt-Out" form. I do this because it is free to do this. I do not need to spend thousands of dollars initially and hundreds more annually for updates for tax preparation software in order to be able to file returns electronically. And I do not have to go through an excessive registration process, provide my fingerprints, and undergo a background check to do so. I simply go to the NJWebFile site and begin to enter the appropriate required information. Any NJ full-year resident can go to the website and file using NJWebFile.

I would gladly submit my clients 1040s (and 1040As) electronically if all I had to do was go to a page within the IRS website and provide the information directly to the IRS with no charge. I would still prepare the actual tax return manually, but would enter the numbers from the manual return as required in the free IRS online filing system.

I have no intention of giving anyone my fingerprints, or of being subjected to an invasive background check. These requirements do not exist for preparers filing paper returns and also should not exist for those filing electronically.

If the IRS is going to require that preparers who file 100 or more 1040 series returns must submit the returns to the government electronically then it also MUST allow the returns to be submitted free of charge with no need to purchase expensive outside software and no additional requirements. And because there are individual taxpayers who may not trust, with or without foundation, electronic submissions to be adequately secure, the IRS must also allow a tax preparer's client to "Opt Out" of electronic filing just as NJ does.

Other components of the IRS "Strategic Plan" for dealing with the Tax Gap, identified in the report, include -

• Make a Multi-Year Commitment to Research,
• Continue Improvements in Information Technology,
• Improve Compliance Activities,
• Enhance Taxpayer Service,
• Reform and Simplify the Tax Law, and
• Coordinate with Partners and Stakeholders.

I am extremely pleased that "Reform and Simplify the Tax Law" is included - an acknowledgement that one of the significant factors in the existence of such a big Tax Gap is the mucking fess that Congress has made of the Tax Code. It is difficult to comply with tax law when tax law is so confusing.

Under "Coordinate with Partners and Stakeholders" the subject of regulation and education of tax preparers, a recent hot topic around the tax blogosphere, is discussed.

I expect that the campaign to reduce the Tax Gap will result in more audits in all areas. This will very likely include increased audits of individual income tax returns that report material Schedule C activity, especially 1040s with continuous and/or substantial Schedule C losses.

So what do you think about the "Tax Gap" and the proposals for dealing with it?

TTFN